Passive management

Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.^[1][2] The most popular method is to mimic the performance of an externally specified index by buying an index fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and low management fees. With low fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.^[3]

Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.^[4]

One of the largest equity mutual funds, the Vanguard 500, is passively managed.^[4] The two firms with the largest amounts of money under management, BlackRock and State Street, primarily engage in passive management strategies.

Rationale

The concept of passive management is counterintuitive to many investors.^[4][5] The rationale behind indexing stems from the following concepts of financial economics:^[4]

1. In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore, the average investor will benefit more from reducing investment costs than from trying to beat the average.^[1][6]
2. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management,^[7] although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
3. The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance.^[8][9]
4. The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under some very strong assumptions, a fund indexed to "the market" is the only fund investors need to obtain the highest risk-adjusted return possible.^[4] Note that the CAPM has been roundly rejected by empirical tests.

The bull market of the 1990s helped spur the growth in indexing observed over that decade. Investors were able to achieve desired absolute returns simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500, Russell 3000, and Wilshire 5000.^[4][10]

In the United States, indexed funds have outperformed the majority of active managers, especially as the fees they charge are very much lower than active managers. They are also able to have significantly greater after-tax returns.^[4]

Some active managers may beat the index in particular years, or even consistently over a series of years.^[11] Nevertheless, the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.^[12]

Implementation

At the simplest, an index fund is implemented by purchasing securities in the same proportion as in the stock market index.^[12] It can also be achieved by sampling (e.g., buying stocks of each kind and sector in the index but not necessarily some of each individual stock), and there are sophisticated versions of sampling (e.g., those that seek to buy those particular shares that have the best chance of good performance).

Investment funds run by investment managers who closely mirror the index in their managed portfolios and offer little "added value" as managers whilst charging fees for active management are called 'closet trackers'; that is they do not in truth actively manage the fund but furtively mirror the index.

Investment funds that employ passive investment strategies to track the performance of a stock market index are known as index funds. Exchange-traded funds are hardly ever actively managed and often track a specific market or commodity indices. Using a small number of index funds and ETFs, one can construct a portfolio that tracks global equity and bond market at a relatively low cost. Popular examples include two-fund and three-fund lazy portfolios.^[13][14]

Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients based on the principle that underperforming markets will be balanced by other markets that outperform. A Loring Ward report in Advisor Perspectives showed how international diversification worked over the 10-year period from 2000–2010, with the Morgan Stanley Capital Index for emerging markets generating ten-year returns of 154 percent balancing the blue-chip S&P 500 index, which lost 9.1 percent over the same period – a historically rare event.^[12] The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.^[12]

There is room for dialog about whether index funds are one example of or the only example of passive management.

Pension fund investment in passive strategies

Research conducted by the World Pensions Council (WPC) suggests that 15% to 20% of overall assets held by large pension funds and national social security funds are invested in various forms of passive funds- as opposed to the more traditional actively managed mandates which still constitute the largest share of institutional investments ^[15] The proportion invested in passive funds varies widely across jurisdictions and fund type ^[15][16]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly ^[17] for various reasons ranging from disappointment with underperforming actively managed mandates ^[15] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.^[18] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.^[16][18]

See also

• Investment management
• Active management
• Exchange-traded fund
• Buy and hold
• Index fund
• Enhanced indexing
• Relative return
• Value investing

References

Further reading

• Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
• John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
• M. Nicolas J. Firzli, "Passive Play: Disenchanted Asset Owners Going Low-Cost as the ‘Age of Austerity’ Lingers", Revue Analyse Financière 54 (2015): 68-70.
• Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9

External links

• The Active vs Passive - unresolved issues.
• The Future of Investment Management
• Lazy portfolios on Bogleheads.org